Italian banks could spark next euro financial crisis

In a world not short of potential triggers for crisis, the increasingly fraught position of the Italian banking system is now looming as the most immediate and perhaps significant threat.

Just how big is the problem? In purely numerical terms it currently stands at around 360 billion euros ($525 billion) - or about 25 per cent of Italian GDP - according to the Bank of Italy.

That includes almost 200 billion euros ($290 billion) worth of bad debts and 124 billion euros in likely defaults as well as assorted other non-performing loans.

Another way of looking at it is that around 17 per cent of Italian bank loans are bad.

To put that in context, the bad debt to total lending ratio in Australia's big four banks is edging up, but still well below the long term average of 0.4 per cent.

How parlous the situation is should be made clearer with the release of results of the European Banking Authority's (EBA) stress test later this month.

On estimates from broking house Morgan Stanley, at least two big banks - Banco Populare and Banca Monte dei Paschi di Siena - will fail to meet previously set levels, although this time around the EBA is not setting an official pass mark, probably to avoid another spate of damaging headlines for the banks.

The stress test only applies to the bigger banks, while some decidedly wobbly smaller ones will escape scrutiny.

The fear is that the frayed nature of the banks' balance sheets will spread into the real economy and ultimately the global banking system.

It is something of a negative feedback loop, with the moribund Italian economy in no sort of shape to help the banks trade out their plight.

Italy's two lost decades

As the International Monetary Fund noted this week, Europe's third largest economy is not looking like recovering until the mid-2020s, by which time it will have endured two "lost" decades of recession.

It is the protracted recession that has largely led to the dire position of the Italian banking system in the first place; that and the failure to grasp the lessons of the GFC about the catastrophic consequences of carrying too much poor quality debt.

The IMF described the need for Italy to fix it its banks and address a range of other reforms as "urgent".

"Downside risks arise from delays in addressing bank asset quality, intensified global financial market volatility - including from Brexit, the global trade slowdown weighing on exports, and the refugee influx and security threats that could further complicate policymaking," the IMF gloomily noted.

If downside risks were to materialise, regional and global spill overs could be significant, given Italy's systemic weight.

So far the policy response has lacked urgency, being more akin to applying a bandaid to staunch the haemorrhaging rather than embarking on life-saving major surgery.

The Italian Government is continuing to talk to the European Commission about a possible bank bailout, but this week's meeting of finance ministers did not include any agreement about supporting Italy's struggling lenders.

Bailout or bail-in? Both have heavy political costs

As Morgan Stanley's Alvaro Serrano noted Italian policymakers are facing a dilemma between the need to reinforce the capital of the banking system, and the need to protect retail savers.

The Government's Atlante fund, established earlier this year with 4.25 billion euros ($6.2 billion) in the kitty to help banks meet minimum capital requirements and buy up non-performing loans, is already down to its last 1.75 billion euros ($2.5 billion) - clearly not enough to get the banks through the crisis.

However, using taxpayers money to bail-out banks would not be popular, nor does it fit comfortably with the European Banking Union's new Single Resolution Mechanism (SRM) which is aimed at reducing the "moral hazard" of allowing the banks to get away with appalling mismanagement and risk taking.

"Bailing-in" under the SRM - getting shareholders and creditors to take the hit - is politically fraught as well, given that in Italy around 200 billion euros of bonds issued by banks are in the hands of retail investors and households.

Shareholders have already taken a hit with the value of banks like Monte dei Paschi losing more than 90 per cent of their value.

"The resolution (using the SRM) of four smaller Italian banks late last year saw loses imposed on retail investors and caused tragic suicide with a resulting high political cost," Michala Marcussen from the French investment bank Societe Generale noted.

"Such a scenario is one that Prime Minister Renzi is understandably keen to avoid replaying. At the same time, Renzi's European partners are also keen to protect the credibility of the new SRM."

So either way the Prime Minister Matteo Renzi is in a bind with his popularity slipping ahead of October's constitutional reform referendum, while the Eurosceptic Five Star Movement gains political momentum.

The referendum is not an "Italexit" vote but aimed at aimed at streamlining the political system, supposedly making it easier to introduce the sorts of economic reforms the EU and IMF are demanding.

Mr Renzi argues that without constitutional reform Italy's fragile political system and continually crumbling governments have little hope in changing things.

If the referendum fails Mr Renzi said he will quit, his centre-left government may fall and the problems will probably become more entrenched.

Italy's problems could spread to Europe's big banks

With Italy sinking in this political quagmire, financial markets - not only in Europe, but globally - are looking on anxiously.

Peninsula Capital Management's Richard Campbell said the predicament of the world's oldest, and Italy's third largest, bank Monte dei Paschi (MdP) - now facing its third bailout since 2007 - is an example of how dangerous the situation has become.

MdP - which has around 35 per cent of its loans in trouble - has seen its assets shrink by 80 per cent from pre-GFC highs, largely thanks to around 500 billion euros worth of "hidden" derivative contracts unearthed by new management.

Mr Campbell points out a counter-party to many of those contracts is Germany's largest and arguably riskiest lender, Deutsche Bank.

"This is the risk of post-Brexit Europe," Mr Campbell said.

Many of Europe's large "quality" banks were being held together by the kindness of the ECB.

"The risk is that if the Paschi rescue isn't enough, Italy's weak three to four juniors plus Paschi will bring down the others.

"That in turn could rattle the German banks, which carry a large part of Europe's total of over 1.2 euro trillion of non-performing loans."

Last month the IMF fingered Deutsche Bank as "the most important net contributor to systemic risks" among the global systemically important banks, or G-SIBs.

That is a worry. Deutsche Bank's US business has just failed the Federal Reserve's latest stress test - the second time in two years - and its shares have been tumbling, down around 20 per cent since the Brexit vote and 45 per cent for the year to date.

The IMF criticised Deutsche Bank for taking on too much debt and having lax risk management.

It also produced a graphic showing just how deeply enmeshed it is in global financial houses.

Disturbingly, two of its closest linkages are with the IMF's second and third "riskiest" banks, HSBC and Credit Suisse.

If the German giant - or one of its close trading partners - unravels under pressure from Italy, debt, Brexit or some other so far unseen nasty, the big risk is the entire fabric of the financial system could fall apart too.